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F FINANCIAL CRISIS INQUIRY COMMISSION REPORTINANCIAL CRISIS INQUIRY COMMISSION REPORT
—was crucial, because these sterling ratings let it borrow cheaply and deploy the
money in lucrative investments. Only six private-sector companies in the United
States in early carried those ratings.
Starting in , AIG Financial Products, a Connecticut-based unit with major op-
erations in London, figured out a new way to make money from those ratings. Relying
on the guarantee of its parent, AIG, AIG Financial Products became a major over-the-
counter derivatives dealer, eventually having a portfolio of . trillion in notional
amount. Among other derivatives activities, the unit issued credit default swaps guar-
anteeing debt obligations held by financial institutions and other investors. In exchange
for a stream of premium-like payments, AIG Financial Products agreed to reimburse
the investor in such a debt obligation in the event of any default. The credit default
swap (CDS) is often compared to insurance, but when an insurance company sells a
policy, regulations require that it set aside a reserve in case of a loss. Because credit de-
fault swaps were not regulated insurance contracts, no such requirement was applica-
ble. In this case, the unit predicted with . confidence that there would be no
realized economic loss on the supposedly safest portions of the CDOs on which they
wrote CDS protection, and failed to make any provisions whatsoever for declines in
value—or unrealized losses—a decision that would prove fatal to AIG in .
AIG Financial Products had a huge business selling CDS to European banks on a
variety of financial assets, including bonds, mortgage-backed securities, CDOs, and
other debt securities. For AIG, the fee for selling protection via the swap appeared
well worth the risk. For the banks purchasing protection, the swap enabled them to
neutralize the credit risk and thereby hold less capital against its assets. Purchasing
credit default swaps from AIG could reduce the amount of regulatory capital that the
bank needed to hold against an asset from to .. By , AIG had written
billion in CDS for such regulatory capital benefits; most were with European
banks for a variety of asset types. That total would rise to billion by .
The same advantages could be enjoyed by banks in the United States, where regu-
lators had introduced similar capital standards for banks’ holdings of mortgage-
backed securities and other investments under the Recourse Rule in . So a credit
default swap with AIG could also lower American banks’ capital requirements.
In and , AIG sold protection on super-senior CDO tranches valued at
billion, up from just billion in . In an interview with the FCIC, one AIG
executive described AIG Financial Products’ principal swap salesman, Alan Frost, as
“the golden goose for the entire Street.”
AIG’s biggest customer in this business was always Goldman Sachs, consistently a
leading CDO underwriter. AIG also wrote billions of dollars of protection for Merrill
Lynch, Société Générale, and other firms. AIG “looked like the perfect customer for
this,” Craig Broderick, Goldman’s chief risk officer, told the FCIC. “They really ticked
all the boxes. They were among the highest-rated [corporations] around. They had
what appeared to be unquestioned expertise. They had tremendous financial
strength. They had huge, appropriate interest in this space, backed by a long history
of trading in it.” 
